Exchange rate issues for Muslim economies

Gulf University for Science and Technology, Kuwait, 12th February 2005

Professor Rodney Wilson, University of Durham, United Kingdom

The falls in the United States dollar’s exchange rate against the euro has proved costly for many Muslim economies, with Saudi Arabia having to pay an additional $2.8 billion for its import bill in 2003. Muslim economies whose currencies are pegged to the dollar have experienced a terms of trade deterioration, as the price of dollar denominated exports, including oil and gas, has declined against imports denominated in other currencies such as the euro, yen, sterling, the Australian dollar and the Swiss franc. Admittedly the renminbi, the Chinese currency, has remained pegged to the dollar, and as China is an increasingly important trading partner for Muslim economies, this tends to reinforce the case for a dollar peg.

There has been no attempt to introduce a common currency for the Muslim World although the former Prime Minister of Malaysia, Dr Mahathir Mohammed, supported the introduction of an Islamic gold dinar, and hosted a seminar on this in Kuala Lumpur in October 2002 following some earlier economic research pointing out the benefits. There are historical precedents as the Umayyad gold dinar circulated during the first century after the Prophet’s death, and some can still be purchased today as collector’s items. Unfortunately as the price of gold is very volatile it is far from certain that such a currency would be a stable medium of exchange or store of value for Muslim economies even if its introduction were practical, which seems doubtful.

Other possibilities for currency standards for Muslim economies include the Islamic dinar, the unit of account of the Islamic Development Bank (IDB). Its value is at parity with the IMF Special Drawing Right, that means in practice it depends on a weighted basket of major currencies including the dollar, euro, yen and sterling, with the former two currencies having the most weight. Apart from for IDB settlements it is not used however for payments purposes, although there is scope for its use as a potential denominator for Islamic sukuk securities, as this might be attractive from the perspective of those wanting portfolios of diverse currencies.

It is also possible that the proposed dinar, that is scheduled to replace the existing currencies of the six Gulf Co-operation Council (GCC) states in 2010, could gain acceptance in the wider Muslim World, and become internationally significant as a medium of exchange and store of value. At present the GCC currencies are pegged to the dollar, but if this link was replaced by a trade weighted peg, and oil and gas prices denominated in the new currency, it would undoubtedly become the most significant currency in the Muslim world, with potential seigniorage gains for the GCC states and other economies that might opt to peg against or shadow the new currency.

The purpose of the paper is to evaluate these possibilities for exchange rate alignment in the Muslim world that might facilitate intra area trade and investment flows. Agreement on exchange rate standards might also bring about an eventual currency union. The study will examine the limited extent to which the Muslim world constitutes an optimum currency and whether progress in meeting the conditions for optimality is possible. At present trade flows are inhibited in many Muslim countries by tariffs, quotas and payments controls, and investment flows are constrained by controls on capital movements. Bilateral and multilateral economic agreements between Muslim states cannot work unless markets are liberalised, as ultimately although governments are responsible for the issue of currency, and central banks can influence their stability through monetary policy, it is markets that determine currency use.

Currency regimes in the Muslim WorldThere is much diversity in the exchange rate systems of the 56 member states of the Organisation of the Islamic Conference (OIC). As indicated above the currencies of the six GCC states are pegged to the dollar, with no changes for 25 years in some cases, as are the currencies of Jordan, Syria, Lebanon and Malaysia. This has brought a degree of stability, notably in terms of domestic prices, in contrast to the situation in the Muslim states of Central and South Asia and Africa, as well as Turkey, where rapid currency depreciation has been accompanied by high inflation, often exceeding 100 percent per annum. However it would be incorrect to suggest that the currency depreciations were the cause of inflation, rather the causation was the reverse, with excess demand in these economies, often reflecting lax fiscal policies, being the underlying problem, with the exchange rate as a dependent variable simply reacting. Fortunately economic management has improved in recent years in some of the states that experienced rapid depreciations, such as Sudan and the Sahara states, and consequently depreciations have become more modest, reflecting their success in combating inflation.

No government in the Islamic World permits its exchange rate to float freely, although when inflation has got out of control, unfortunately all too frequently, so has the exchange rate. Some governments however, usually with encouragement from the IMF, have adopted policies of managed floating, most notably Iran and Egypt. Under managed floating the central bank does not commit to any exchange rate target, but aims to reduce currency fluctuations through direct interventions in the foreign exchange market, and by using interest rates as a tool to encourage capital flows to offset current account imbalances. Of course from a shariah perspective the use of an active interest rate policy is at best dubious, and for many unacceptable, not least because it has implications for returns on domestic deposits and the cost of borrowing.

The experiences of Iran and Egypt with floating have been very different, reflecting partly the underlying economic fundamentals, but also how effectively the floating has been managed. In Iran the gap between the official exchange rate and the unofficial rate increased substantially in the 1990s with the evasion of Central Bank controls, which was a major factor in brining about a policy change in favour of floating rates. Nevertheless Iran started floating from a position of greater strength in 2000, largely due to high oil prices and a consequent trade surplus, while in Egypt a chronic trade deficit prevailed. Iran already had experience of a market-determined exchange rate, as although the official rate was pegged, there was a parallel rate that was determined through the Tehran Stock Exchange that hosted currency as well as security dealing. In contrast in Egypt the dual exchange system prior to 2000 comprised an official fixed rate peg, and an unofficial black market that the authorities had little control over. Furthermore once Iran introduced its floating rate, transactions were handled through an inter-bank foreign exchange market, but there was no Egyptian counterpart to this.

In Egypt floating resulted in a rapid depreciation of the Egyptian pound, from LE3.69 per $US at the end of 2000 to LE4.49 1 per $US by the end of 2001. This however did not result in a rising exports, as oil, the largest single export, is dollar denominated, and therefore the exchange rate of the local currency is irrelevant to sales. There was a lagged effect on imports of goods and services, which declined from $US 21.8 billion in 2001 to $US 19.5 billion in 2002, but this was insufficient to reduce the current account deficit significantly. Meanwhile industrialists and distributors complained about the increased cost of supplies in local currency terms, and the deterioration in purchasing power. The response of government was to adopt an adjustable currency band in January 2001, but in practice the unfavourable economic fundamentals meant this band was depreciated on five occasions and widened twice between 2001 and 2003, which discredited the exchange rate targeting policy. Furthermore in so far as the move from managed floating to a banded system delayed depreciation, this only encouraged unofficial foreign exchange transactions through a black market.

Whereas Iran and Egypt have moved to more flexible exchange rate systems, Malaysia moved in the opposite direction after the 1997 Asia crisis, the decision being to peg the exchange rate to the US dollar after the initial devaluation. The aim of this policy was to being stability, notably to avoid getting into a spiral of depreciation bringing price rises due to increased import costs, which in turn might result in further depreciation. Although the long-term evidence seemed to suggest that purchasing power parity had not explained exchange rate movements of the Malaysian ringgit over the 1973-1997 period, the subsequent inflationary pressure was viewed as a threat in the aftermath of the Asian crisis.

Capital controls were reintroduced to facilitate the management of Malaysia’s fixed exchange rate, as many in government argued that the liberalisation of the capital account and the excessively generous policies to attract inflows of foreign portfolio investment made the country vulnerable in times of crisis when such capital inflows were soon reversed. The pre crisis evidence suggested some instability in the market for foreign exchange, although there was no “J” curve effect for Malaysia with depreciation resulting in a temporary deterioration in the trade balance before the more competitive exchange rate eventually helped export sales.

One unwelcome aspect of Malaysia’s fixed exchange rate policy from a shariah perspective was the greater use of interest rates to support the policy, as rates had to move in line with those prevailing for the US dollar, and in addition in times of currency threats and perceived risks to the ringgit differentials between US dollar and the Malaysian currency were increased. As the historical evidence suggested that money supply growth was a major factor explaining Malaysian trade balances, this emphasis on interest rate policy was probably inevitable given the relationship between money supply and interest rates.

An Islamic World optimum currency areaThe standard approach to examining whether groups of countries should align their currencies with the ultimate aim of establishing a currency union is set out in the optimum currency literature, the pioneering work on which was undertaken by Robert Mundell and Ronald McKinnon. The three major conditions for optimum currency unions to be successful are firstly that resources, notably labour and capital, should be mobile amongst member states; secondly, the economic structures should be similar, and thirdly, there should be a willingness to closely co-ordinate monetary, fiscal and other economic policies. These conditions were much discussed in the context of the Maastricht Treaty that set the convergence criteria for states being accepted for membership of the European Monetary Union. These provided for inflation, interest and exchange rate convergence, as well as targets for budgetary deficits and government debt.

Although labour and capital movements between Euro Zone members are limited, there are extensive trade ties, which results in the area functioning as a single market for goods. Typically between half and four fifths of the trade of Euro Zone countries is with other members of the Zone. In contrast as table 1 shows the share of intra-trade between OIC member states is very limited, averaging only around 11 percent of exports and 14 percent of imports. Six states dominate intra-OIC trade, UAE, Saudi Arabia, Malaysia, Indonesia, Turkey and Iran, ranked in order of significance according to the value of their exports and imports. Together these six states account for two thirds of intra-OIC exports and over 63 percent of intra-OIC imports. Oil exports and imports accounts for much of this trade however, and it is difficult to identify complementarities and sources of comparative advantage in other sectors from an OIC perspective.

Given the substantial disparities in economic development and differing economic structures in the Muslim world, there is no possibility of the Mundell and McKinnon conditions being met for the foreseeable future. There are restrictions on movement of labour between all OIC countries with increasingly restrictive conditions governing work permits in order to encourage the employment of local citizens rather than foreign workers. The GCC countries have absorbed many workers from the Arab World, Pakistan and Bangladesh, but Saudis, Kuwaitis and other local citizens have now replaced most Egyptians, Jordanians and Palestinians working in the public sector. Meanwhile employment of foreigners, including nationals of other OIC countries, in the private sector is becoming more tightly controlled. Similar restrictions apply in Malaysia, where illegal migration from Indonesia is a perceived problem, and there are few work permits issued to Indonesians.

Mundell and McKinnon also postulate that free mobility of capital movements and indeed a degree of financial market integration is also a pre-requisite for a successful monetary union. In reality there are few capital investment flows between Muslim economies, partly reflecting the limited degree of stock market development and the restricted scope for portfolio investment flows. It is only in Saudi Arabia and Malaysia where stock market capitalisations exceed $100 billion and it is only in Malaysia where there is significant trading in government bonds, including Islamic sukuk certificates.

Most of the portfolio investment flows recoded in table 2 refer to outflows of capital from the Muslim World to developed countries rather than inflows. The absence of multinational companies with head offices in the Islamic World limits the scope for foreign direct investment (FDI) flows between Muslim countries. Even movements of FDI between Muslim economies and the entire global economy are miniscule as table 2 illustrates. Financial market integration in the Muslim World is also impeded by the foreign exchange controls that are applied universally to the export of capital, the GCC states being the major exception, although much of the funds originating in these countries are invested in the West rather than the Islamic World.

For Muslim monetary union to be successful this would involve setting and meeting convergence criteria similar to those agreed at Maastricht, and subsequently, apart from the debt criteria, largely implemented by countries adopting the euro. As inflation rates vary from over 40 percent in Turkey to virtually zero in the GCC states, and as interest rate differentials and exchange rates movements reflect these disparities, there is little prospect of convergence.

Global monetary developments and OIC currenciesGiven the obstacles preventing monetary union in the Muslim World, many researchers have adopted the less ambitious, but undoubtedly more realistic agenda, of examining how individual Muslim states and groupings of states can influence discussions on the reform of the international monetary and financial system at the global level. This involves consideration of how the exchange rate policies supported by the International Monetary Fund (IMF) can be best adapted to serve the interests of the OIC countries, including their wish to see closer intra–OIC economic links through trade, commerce and capital movements.

There has been much consideration of the impact of global economic change on exchange rate options and wider macroeconomic management issues at the sub-OIC level: notably in relation to the Muslim states of the Middle East and North Africa. Inappropriate exchange rate policies, especially real exchange rate overvaluation and delayed currency adjustment, are identified as impediments to economic growth and diversification. Policies adopted by Egypt, Jordan, Morocco and Tunisia have been seen as unhelpful for growth, as have the policies adopted in Iran. Problems of exchange rate policies have been recognised by the IMF, and it has given advice on the establishment of inter-bank exchange markets in Morocco and Tunisia, the unification of exchange rates and the transition from multiple rates in Iran, Libya and Yemen and the implementation of flexible exchange rate arrangements and supporting monetary policies in Egypt, Pakistan, Sudan, Tunisia and Yemen. This diversity of recommendations could be regarded as a positive attempt by the IMF to adjust its advice to particular circumstances of each country, but more negatively it could also be interpreted as a symptom of the failure to devise a more comprehensive exchange rate strategy for the international economy, or even for country groupings such as the Arab World or wider OIC.

There has, not surprisingly, been considerable interest in the OIC in the successful introduction of the euro and its impact on participating countries. The Euro Zone provides a model for currency union amongst OIC countries or sub-groupings within the OIC, and at the same time provides a real alternative to the United States dollar, both as a reserve currency to hold, and as a medium of exchange. The euro is seen as a significant means of payment given its widespread international acceptability and the substantial volume of trade and capital movements between OIC countries and the Euro Zone member states. It is of particular significance for OIC countries that are aspiring members of the European Union, notably Turkey, and Mediterranean Arab countries such as Egypt, Tunisia and Morocco that have co-operation agreements with the European Union providing for eventual free trade. Historically most of the trade of these countries was with Europe, and these trade links have been maintained, and in some respects strengthened in recent years.

The gold dinar as a parallel currencyMuhammad Anwar attempted to compare the adoption of the euro to the possible adoption by Muslim countries of the gold dinar, but concludes that the adoption of a currency union is not feasible for all Muslim states. Instead he argues that the gold dinar could be introduced as a parallel currency for interested Muslim countries on a voluntary basis. There was in the immediate period after the Maastricht Treaty in 1990 a British proposal to let European Union countries use the euro in parallel to their national currencies, with the public deciding, in the light of their salary and payments preferences, what currency to use. This never took off however, as although in countries outside the Euro Zone some retail establishments accept payments in euros, as people are paid in their national currencies, there is naturally a risk aversion to having a currency mismatch between receipts and payments, or in other words taking on foreign exchange exposure.

Rather than introduce the gold dinar at the retail level, Malaysia has entered an agreement with Iran to settle payments balances using gold dinar. There is little trade between these two OIC states however, and merely having central banks involved in very limited settlements at international level is unlikely to capture the public imagination. Muhammad Anwar argues that the introduction of the gold dinar would end currency speculation, but as the price of gold is unstable, and there is much speculation in gold markets, it is not clear how a gold dinar would be immune from such pressures.

Proponents of the Islamic gold dinar argue that its intrinsic value would be based on the price of a unique precious metal in limited supply, whereas governments running excessive fiscal deficits can abuse paper currencies, or even simply print money, as in some OIC countries. Arguably a first best solution however is to impose greater fiscal discipline, not simply adopt a precious metal, the supply of which responds imperfectly to prices. Even during the period of the Gold Standard prior to 1914, monetary demand was only one component of the demand for gold, the major demand being for jewellery, which was of course subject to fashion that determined price swings. Furthermore apart from Kazakhstan, there is little gold mined in the Muslim World, and although one of the proponents of the return of the gold dinar was South African, less than five percent of that country’s population are Muslim.

Currency alignment for able and willing Muslim states:There are strong arguments for currency alignment amongst Muslim states, as it would be helpful in facilitating trade and payments, and in integrating Muslim capital markets and potentially reducing the cost of funding. Currency alignment could also help in the development of markets in Islamic financial instruments, notably sovereign and corporate sukuk securities. To some extent the debate over the Islamic gold dinar is a distraction, as a better means of promoting eventual monetary union amongst Muslim states is to build on existing economic strengths, by aligning the currencies of the more economically successful Muslim economies. In particular currency alignment between the GCC states and Malaysia would create a critical core for an Islamic monetary union that other Muslim states could in due course join when they had a realistic chance of being able to adhere to the convergence criteria. It could be a step towards a monetary union for the Muslim states of Asia, and perhaps eventually the Muslim countries of Africa.

Economic links between Malaysia and the GCC states have deepened considerably in recent years, with MayBank, the leading Kuala Lumpur based financial institution, opening a branch in Bahrain in 2002, and several Gulf banks represented in Malaysia, including the Kuwait Finance House which opened a Kuala Lumpur branch in 2004. The Malaysian government issued Islamic sukuk certificates worth $600 million in 2002, and GCC investors purchased over 60 percent of the issue. By 2003 Malaysian exports to the UAE, its largest trading partner in the Muslim World, were worth $1.4 billion, this comprising diverse industrial supplies including electrical goods. UAE exports to Malaysia, mainly oil, gold and non-ferrous metals, totalled $400 million for the same year.

Early attempts at Arab economic integration in the post colonial period failed, including the very ambitious United Arab Republic between Egypt and Syria over the 1958-1961 period. The Arab Common Market, modelled on the European Common Market, and launched by President Nasser of Egypt in 1964, also failed, as only Syria, Iraq and Jordan joined, and intra-Arab trade failed to take off.

In the GCC however, free trade was easier to achieve, as all of the countries were in a more favourable trading position because of their oil exports, and there were no restrictions on import payments. Deeper integration came in 2002 when the free trade area was superseded by a customs union, with all GCC states adopting a common tariff of five percent, and internal controls being removed on the movement of goods. As the GCC countries had already many of the pre-requisites of a common market, notably no outward restrictions on the movement of capital or local nationals, further moves towards even closer economic integration were relatively easy to agree. As a single currency was seen as essential for an effectively functioning customs union, it was only natural to take this further step.

The aim of the GCC states is to achieve monetary union by 2005 and for a single currency, probably designated as a dinar, to replace the six existing currencies by 2010. Achieving this ambitious goal will be a considerable challenge, as there is still a lack of convergence in GCC economies. Although inflation is low in all six countries, consumer price indices differ, with higher price rises in the UAE where economic activity is most buoyant creating demand pressures. Real growth disparities are considerable, especially in the non-hydrocarbon sector. Fiscal discipline amongst the GCC countries is also a pre-requisite for monetary union, as there is much variation in government debt, with that for Saudi Arabia amounting to $168 billion, or 94 percent of GDP, while that for the UAE is negligible.

Monetary union and the adoption of a single currency in the GCC will require strong political will, but many opinion makers are convinced of its merits. The elimination of transactions costs is seen as crucial for intra regional trade promotion, and the greater cross border price transparency for goods and services should boost competition. This would be further enhanced by the reduction in payments charges by banks. The cost of capital should also be reduced as financial markets become more competitive and efficient. The emergence of a single stock market is unlikely, as this has not happened in the European Union due to regulatory and legal differences, and there are similar differences in the GCC. Nevertheless from 2002 companies listed in one GCC stock exchange have been able to seek listings in other member states, and banks with a licence to operate in one state were allowed to conduct business throughout the GCC. By 2004 the National Bank of Kuwait, Emirates International Bank and the Bahrain based Gulf International Bank had all opened branches in Riyadh.

The lessons from European monetary union have proved useful for the GCC, and the European Central Bank has conducted a study of the proposed GCC monetary union. There will be a committee of GCC central bankers responsible for the management of monetary policy from 2005 rather than moving initially to a single central bank. The aim of the new unified monetary policy will be to maintain the parities of the GCC currencies with the United States dollar and keep inflation at a minimal level, although it is not clear whether there will be an agreed inflation target. There are concerns about unemployment in the GCC countries, and these have been discussed at regional level. Excessively tight monetary policy that raised borrowing costs could potentially be detrimental to the employment of local GCC nationals.

A benchmark for pegging or floating Muslim currenciesPerhaps the most crucial issue in the long term for the GCC states contemplating currency union is whether the new Gulf dinar will be pegged to the dollar or a basket of currencies or permitted to float freely. A team from the IMF has studied whether pegging the new currency to a basket comprising dollars and euros would be preferable to pegging solely to the dollar. Their finding was that given current trading patterns there was no significant advantage from moving from a dollar peg to one based on the euro and the dollar, largely because the prices of GCC oil and gas exports are dollar denominated and most of the invoicing for imports from Asia is in dollars. As most overseas assets held by GCC governments, companies and families of high net worth are also dollar denominated, this reinforces the case for the currency alignment with the dollar.

The substantial dollar depreciation against the Euro during 2003 and 2004 has unsurprisingly resulted in increased debate about the merits of a dollar peg for GCC currencies and even whether the price of oil exports should continue to be denominated in dollars. Although by May 2004 the oil price had risen to over $40 per barrel this was only 40 percent of the level in 1980 because of the decline in value of the dollar. There has been a political desire to diversify the relations by the GCC states given their differences with the United States over its policies on Palestine and Iraq and the wider Middle East policy of the Bush administration. This has been reflected in the economic sphere by a move from dollar asset holdings to those denominated in euros and GCC currencies, and there has been also a desire to widen trading relationships.

As GCC economies become more diversified moving away from the dollar parity makes sense, as a more flexible exchange rate policy, aimed at maintaining and enhancing competitiveness, may be more appropriate. At present the GCC countries are price takers rather than price makers with respect to their currencies, as it is the domestic economic policy agenda in the US that determines how their currencies move against the euro and yen, not developments in the GCC. This is clearly an unsatisfactory state of affairs, not least as interest rates in the GCC are in practice dictated by movements in US dollar rates, with SIBOR, the Saudi Inter Bank Offer Rate mirroring LIBOR, the London Inter-Bank Offer Rate on dollars. If the GCC states are to enjoy greater monetary autonomy, then the peg with the US dollar must be rethought.

If the prices of GCC oil and gas exports were denominated in the new Gulf dinar, and the currency itself allowed to float against other currencies, many oil and gas importers might choose to hold the new Gulf currency for payments purposed. Such holdings would be a means of hedging against increases in the price of oil and gas in terms of dollars, euro and yen. The new currency would therefore result in seignorage gains for the GCC governments, as oil and gas importers acquired treasury bills, bonds and other sovereign issues. As the price of oil and gas would be stable in the new Gulf currency but less stable in terms of dollars, euro or yen, oil importing Muslim countries might choose to peg their currencies against the new Gulf dinar, creating in effect a monetary union for the Islamic world, or at least for those Muslim states able and willing to participate.

With a unified floating Gulf currency the exchange rate would respond to changes in energy prices and energy market conditions. Rising demand for energy would cause the currency to rise, lowering the cost of funding for investment in oil and gas production, which would ultimately increase supply capacity. A fall in the demand for energy would weaken the exchange rate, making energy cheaper, and hence encouraging demand. Government finances would be to some extent insulated from energy price cycles, as prices would fluctuate in foreign currencies, but not in Gulf dinar, and hence oil and gas revenues for GCC governments would remain unchanged even if the dollar price of energy fell.

There would however be negative features of having the Gulf dinar floating, and its de facto value determined by energy market developments. Changes in the terms of trade might become more pronounced, as these would improve when energy prices were buoyant and the currency appreciated, but would deteriorate when energy prices decreased. There would also be a risk of Dutch disease, with non-energy exports being crowded out when international energy prices and hence the Gulf dinar were rising. Furthermore other Muslim countries with no or minimal energy sources such as Malaysia might find being pegged to an oil and gas dependent currency unattractive, as their exports of manufactured goods could suffer if the new dinar appreciated because of energy shocks.

There are no simple short-term solutions to these potential problems. In the longer term as more Muslim countries with significant exports of manufactured goods and earnings from services adopted the new currency, and it evolved from being a Gulf dinar to a true Islamic dinar, the relationship between the exchange rate and energy prices would weaken. The foreign exchange earnings of the Islamic dinar bloc would then become more diversified and balanced, helping currency stabilisation. There would be real incentives for diversification, both in terms of widening the currency bloc through the admission of new members, and for deepening in terms of building up the export and service sector earning capacity of existing states in the bloc.

A new Islamic dinar could emerge as the currency of choice for the issue of Islamic sukuk securities that have so far been entirely denominated in dollars, the exception being a modest issue in euros by a German regional government. Apart from the international sukuk issue by the government of Malaysia for $600 million mentioned earlier, there has been a $700 million issue by the government of Qatar, and over $1 billion attracted by Bahrain through a series of issues since 2001. In addition to these sovereign sukuk, there is much scope for corporate sukuk, especially to fund the expansion of utilities and transportation. Emirates Airlines is planning to issue sukuk, and Hanco, a car rental company in Saudi Arabia, has already obtained financing through a sukuk issue. As the money raised is mainly to be utilised in the GCC and Malaysia, local currency rather than dollar issues may be preferable. Furthermore as major holders of sukuk in the future are likely to include Islamic takaful insurance companies and pension funds, these institutions may have a preference for new Islamic or Gulf dinar assets to match their dinar liabilities.